Should I Use A Traditional Or Roth IRA?

Understand Which Saving Vehicle Works Best For Your Retirement Plan

People often wonder what type of IRA is best. Both the Traditional and Roth IRAs have significant tax advantages, but in some situations one may be better than the other. Since we can't predict what taxes will be like 20 years from now, if you have the ability to contribute to both types of IRAs, that might be a good idea. By diversifying your tax liabilities, you can be prepared for any significant changes in tax rates by the time you reach retirement.

First, let's explore what each type of IRA is by definition. A Traditional IRA is a type of Individual Retirement Account where you contribute pre-tax or after-tax dollars. It also allows your money to grow tax-defered. You can begin making withdrawals on money from your Traditional IRA account after 59½. Once you begin making withdrawals, it is treated as current income. A Roth IRA is another type of Individual Retirement Account that allows you to set aside after-tax dollars up to a specified amount each year.

You can begin making withdrawals on money from your Roth IRA after age 59½ are tax-free, and your withdrawals will continue to be tax-free.

Characteristics of Traditional and Roth IRAs

Traditional IRA

The benefit of a Traditional IRA is that the contributions you make can be tax-deductible in the year that you make the contribution. That means if you make a $5,5000 contribution into a Traditional IRA this year (or $6500 if you are over age 50 or older), you can reduce your current taxable income by $5,500 (or $6,500). For individuals who are in a higher tax bracket, this can be a reasonable savings.

Since the contributions are done on a pre-tax basis, that means you will be taxed in the future when you withdraw money from the IRA. This money is then taxed as ordinary income. If you expect to be in a lower tax bracket when you retire, this means you see the greatest tax benefits from a Traditional IRA. Keep in mind that you must begin taking required minimum distributions at age 70½.

Roth IRA

You can think of a Roth IRA as the opposite of a Traditional IRA in terms of taxation. With a Roth IRA, your contributions are made on an after-tax basis, which means there is no current tax benefit to you when you make a contribution. However, you will benefit on the other end, and qualified distributions from a Roth IRA are tax free. This typically benefits those who expect to be in a higher tax bracket upon retirement. Contribution limits to a Roth IRA are the same as they are to a Traditional IRA: $5,500, and if you're 50 or older, $6,500.

Additionally, Roth IRAs do not require that you take required distributions upon reaching age 70½. This can be increasingly important as people are living and working longer. Also keep in mind that there are income limitations that may prohibit higher income individuals to participate in a Roth. These income limits are slated to be lifted in the year 2010.

Ask Yourself These Questions

As you weigh the pros and cons of the Traditional and Roth IRA, here are some questions that may ask yourself or discuss with your financial advisor.

Do you expect your income to increase or decrease in retirement?

Do you expect your tax rate to be higher or lower when you retire?

What is your current tax bracket?

How much income do you need on a monthly basis once you retire?

Bottom Line

Making a decision between a Traditional and Roth IRA may be difficult if you are eligible for both. You will want to weigh the pros and cons of being taxed now versus being taxed later. You may also make considerations on what will work best for you based on income limits, contribution limits, tax incentives, withdrawal rules, and future tax rates.

If you are confused or unsure how to proceed, it is always a good idea to speak with a qualified financial planner or visit the IRS website for additional information.